Cooperatives, Legislation andPublic Policy:

Political, strategic and technical pre-conditions for Effectively RegulatingFinancial Services Cooperatives

by Peter van Dijk, Consultant Microfinance

CONTENTS

  1. Introductionpage 1
  2. Role of Governmentpage 4
  3. General Principles of financial services cooperativespage 9
  4. The risks of government and foreign supportpage 21
  5. A possible development process for financial services coopspage 22
  6. Conclusionpage 23
  1. Introduction, country experience with Microfinance Cooperatives

The main objective of the paper is to explain how policies, laws and regulations can build a framework that can successfully enable and support the sustained growth of cooperative societies that provide financial services for unbanked people in countries with massive poverty challenges and an underdeveloped infrastructure.National regulators can only undertake a strong enabling and supporting role when they understand well the principles and governance rules of financial services cooperatives and are able to decide on their interpretation and application.

This paper is basedonworkingon regulation & supervision in microfinance and financial sector development inEast Africa (Kenya, Tanzania, Uganda), West Africa (the 8 Francophone member countries of the UEMOA, plus Guinea and Mauritania), Southern Africa (Madagascar and South Africa), Cambodia,Laos, Pakistanand Indonesia. In all these countries operate or operated financial institutions established as cooperative societies. These organisations aim specifically at providing financial services in a sustainable manner to citizens that are not clients of banks.The main reasons for which they are not banked are that they have low and unstable incomes and/or that they live in areas where commercial banks do not operate (no branches, no agents, no mobile banking activities). Recognising that financial services are important for people in managing their lives and in improving them, governments and aid agencies have undertaken initiatives in all the above-mentioned countries to support the development of financial services cooperatives as an alternative to banks.

Savings & Credit Cooperatives (Sacco’s), or similarly organisedmicrofinance institutions (MFIs) such as Village Banks, have operated for over a centuryin many African countries During British influence, cooperative movements were started inEast Africawith British support and cooperative departments were established in governments[1]. International Cooperatives’ organisations, Sacco and Credit Union (CU) specialists as well as other donor agencies[2]subsequentlycollaborated with East African Sacco’s. Performance assessmentsmade over the last years report that Sacco’sin the region have crumbled or facemany common challenges that will be explained below.

In the FrancophoneWest African UEMOA region (8 member countries, some 80 million inhabitants) hundreds of MFIs registered with national MF departments in the Finance Ministry who have no means to effectively supervise them. As a consequence of a foreign donor project[3], the cooperative societyis the dominant legal status of MFIs in this area. Recently the regional central bank (BCEAO) started a program with supportfrom aid agencies to help improve ministerialsupervision of the largest MFIs. Some of these Coop MFIs have hundreds of thousands of members and collect the equivalent of millions of US$ in deposits and savings of poor and/or rural citizens. This region’s MFIs havea highcoveragerate (some 10% of the population). Over the last five years external loans and investmentsto MFIs are increasingwhilst member savings aredecreasing. At the same time, Portfolio at Risk hovers over five per cent, wellbeyond BCEAO’sstandard of three per cent (its definition of PAR is lenient too, three months past due, where global best practice defines it as one month past due)[4].

In South Africa, some 30 Savings and Credit Cooperatives are member of the SACCO League (SACCOL). Since its creation in 1993 these Sacco’s report around 10.000 members[5]; they are mainly credit oriented and donor dependent. Most are small and weak. When discussing with SACCOLthe winding up of weak members,its MD explained that their weakness has been due to insufficient political support and donor grants, although they already depend on such support. Sacco’s have also been created by government departments, trade unions and individuals. The central (Reserve) bank is responsible for the Sacco’s but seems to undertake few activities. A Mutual Banks Act was established in 1993 but no Sacco has been able to transform itself into a mutual bank[6]. In 2008 a Cooperatives Bank law was introduced. The law gives special attention to support organisations, collecting and managing grants and establishing a specific Cooperative Banks Development Agency. No attention was given to principles for the proper functioning of a cooperative bank, their savings orientation, the common bond between founding and client members, voluntarism, financial autonomy and active member control.

In Pakistan, a big country with some 170 million people many of whom are poor and/or live in rural areas, cooperative societies providing financial services were created half a century ago with strong government support. Many failed dramatically, together with provincial cooperative banks which functioned as wholesale organisations,nearly all have beenclosed down.The central bank (SBP) concluded in a report last year that the main reasons for failure were politicisation, misappropriation and fraud (especially by wealthy landlords),bad collaboration between federal and provincial government, credit-focus and external (mainly federal) funding for credit. Neverthelessits Governor proposed a revitalisation of the MF coop-s under a different name, Credit Unions[7].

In Cambodia and Laos cooperative societies have been identified by foreign donor agencies as a promising set-up for MFIs notwithstanding the reticence of government and citizens due to past communist-inspired experiences. Foreign agencies requested central banksin both countries to allow them to create and operate cooperative MFIs with a mild information obligation. These coops have limited operations. In Cambodia, donor dependent MFIs mainly set up as NGOs are busy transforming into MF businesses regulated by the central bank; one even transformed itself into a commercial bank with financial and technical assistance of development finance institutions[8].

Finally, Indonesia is a vast country of thousands of islands with the world’s fourth largest population of about 237 million inhabitants, nearly half of whom (according to a 2006 Poverty study of the World Bank) depend on less than 2 US$ income per day, the recently adopted UN standard of absolute poverty. The microfinance sector is diverse, with state-owned banks (such as BRI, considered the world’s largest MF services provider), private banks, rural banks, community non-banks, government credit programs, NGOs and foreign agencies. There are also tens of thousands of MF services providers that are established as cooperative societies by government, NGOs and foreign aid agencies. The Government (Ministry of Cooperatives) and not the central bank is responsible for their regulation and supervision but has no reliable data on the number of these MFIs, their members, their operations and performance.

  1. What is required from Government when it chooses to support cooperatives as an instrument to provide financial services to poor and rural citizens?

In industrialisedcountries and regions, such as in the European Union (EU), local government is in charge of the policy and regulatory framework in microfinance and financial sector development. Local regulators thus also decide on the legal status financial institutions can have and determine the possible role of cooperative societies. Since commercial banks in the EU complained about unfair competition and abuse of financial terms (rules that protect consumers), the EU decideda few years ago that MF in the EU would be defined and could only be undertaken as social credit activities; such activities are thus not financial or banking services and cannot be called such. Social organisations such as NGOs and Associations that provide these MF activities are not allowed to call themselves banks or financial institutions and cannot use terms or parts of these terms to give that impression. They are of course not regulated by financial authorities. However, such NGOs, Foundations, Funds (such as the world’s biggest MF Fund EFSE supported by KfW) may, together with national aid agencies, development banks (such as EBRD, EIB, DEG, FMO) and social responsibility departments of companies (also of well-known banks such as Deutsche Bank, Kommerzbank, Credit Mutuel, Rabobank, Cajas de Ahorros and many others), undertake microfinance activities as they want outside the EU. They mix social with commercial objectives and activities. This clear separation is expressed by the EU’s MF Strategy[9] and by the two different European MF associations[10].

MF activitiesthat socially motivated organisations (mainly from North America and Western Europe, Japan and the Arab oil and gas nations)undertake can compete with banks and other regulated financial institutions and are in many countries at odds with banking laws. Government and financial sector authorities do not often act against these initiatives as the foreign projects benefit many of their poorest citizens who do not have access to banks; their unbanked population is often large and the basic need for financial services well recognised, especially since the efforts of Professor Yunus’ GrameenBank and the initiative of United Nations 2005 YearofMicroCredit[11] received world-wide attention. Also governmentsthemselvesundertakeMF activities. Theyoffer programs targeting agriculture,women, youth, irrigation, poverty alleviation, social development, enterprise development, unemployment, refugee programs, integration of ex-combatants, handicapped people and so forth and so on. Many governments also promote financial services cooperatives (also called credit unions, village banks or equivalents in other languages) outside of the financial sector, as part of socio-political initiatives. And cooperative initiatives are also undertaken by political parties, trade unions, NGOs, associations, local leaders, political hopefuls etc.

This wide array of MF activityhas yet todemonstrateMFI’s potential for structural poverty alleviation and the role financial coops can play.Governments will need to take two important decisions before it can successfully support the development of sustainable professional, therefore regulated and effectively supervised, financial services cooperatives, which are able to strengthen the MF sector:-

  1. Microfinance is a tool for building an inclusive formal, regulated, financial sector that ensures that all citizens benefit from safe, professional financial services and that they are protected against abuse and bad practices;
  2. If MF is a part of the formal financial sector, then financial services cooperatives need to be regulated (and effectively supervised, ensuring full compliance of laws and regulations) by Financial and Cooperative authorities.

Over the last five years, most if not all above-mentioned countries have adopted national Microfinance strategies. Often these strategies were developed and written with substantial support of foreign donors. Many stakeholders listed above have provided opinions, often at workshops moderated by consultants and foreign experts. As one might therefore expect, many of these strategies look like wish-lists of the different MF services providers.Resulting strategies I have seen define MF as a tool to build an inclusive formal financial sector,but they often focus on credit to micro-enterprises or to other specific target groups (e.g. poor people, rural citizens, peasants, women, youth). A national strategy in which MF is a tool to provide access to financial services to all citizens should not focus on one or a few financial services, nor should it focus on specific categories of clients. Doing so increases the riskof making such strategies exclusive instead of inclusive, or of making them sensitive to political influences, whichrepresentsapowerfulopponent of using Microfinance as a tool in financial sector development (FSD).

Another important consequence of deciding that MF is a tool for building an inclusive formal financial sector is that the un-banked or alleged non-bankable citizens will be considered as full citizens and thus have rights as anybody else. They are not victims of society, but citizens with effectively protected rights on accessingand using financial services, including legal protection and education[12]. Recognising that every citizen requires financial services and support to be able to efficiently use these services, government, civil society and foreign partners need to accept thatunbanked poor people can hold them accountable for results.Governments and other stakeholders need to be conscious of the importance for long-term collaboration and commitment, transparency and consistency in achieving such results in MF/FSD.

Cooperative societies represent a specific legal and practical form for organising economic activities. Cooperative societies that provide financial services need to undertake these services in a professional manner but they continue to be cooperatives as well. Even Cooperative Banks in developed countries have to comply with cooperative rules as well as with rules established by financial authorities. This makes regulating financial services cooperatives complex. Furthermore, as everyone knows and which will be explained in the next chapter, financial services coops are based on voluntarism and a common bond between members. They normally start small and often operate in remote areas with low population density. That makes regulating and supervising them more difficult and more costly. All regulation is costly, but financial sector regulation is even more so; government has to ensure that the money it issues is safe and soundly managed, otherwise the entire society and economy maybe destabilised. One should be careful comparing money and financial services with other goods and services.

Financial sector regulation is most often triggered by three factors: (i) does the financial services provider in question bear systemic risks, (ii) are deposits/savings of the general publicin danger, especially those of lower income people, and (iii) do issues exist that obstruct market-oriented development of the financial sector?

As financial sector regulation is costly and requires full compliance, financial regulators and supervisors apply a risk-oriented approach and focus on financial institutions that can destabilise the entire financial system. As most financial cooperatives are small, not integrated into the financial sector and depend mainly on member shares and deposits for their operations, they do most often not bear systemic risks. Cooperatives are created, funded and controlled by their members. They determine their own rules and application and thus do not endanger public deposits. Risks thus increase with their scale of operations; the number of clients and their interaction with the financial sector and other parts of the economy.

The market-orientation of the financial sector,the stable value of money and the quality of financial services all depend on free choice and transparent performance measurementin that specific market. Financial authorities want to ensure transparency on offer and demand, they want to ensure fair trading practices and they want to ensure that there are sufficient incentives for a wide and deep banking sector. Only an inclusive financial sector can ensure stability and be a strong support for sustained and broad economic growth and job creation.

Government can only regulate activities that exist and can be verified. Regulation is not an instrument that promotes the creation of financial coops. In South Africa two laws were developed with international support, but still there does not exist even one Cooperative Bank; not even one Financial Coop created with important political, financial and technical support was able to develop into a sustainable financial institution that can be regulated.Effective supervision obviously demands that data can be collected and verified. In many countries the regular production and reporting of reliable data is the main challenge of the Microfinance sector; regulating organisations that cannot produce verifiable data and that cannot be held accountable for such weakness does really not make sense. This is often true also for financial coops.

For all the above reasons, it can thus be concluded that financial authorities need to collaborate with cooperative authorities for the regulation of financial coops.

  1. What are the general principles of financial services cooperatives that policies, laws and regulations need to comply with at all times?

III.A.The importance of agreed Cooperative principles in the MF context

There are different definitions of financial services cooperatives and different interpretationsof their rules and operations. Variations concernprofit objectives, set-up on different levels (local, regional, national), ownership, governance, management, board members, operations, competition, liquidity management, working with banks. All these issues need to be integrated into the regulatory framework in a consistent manner depending on acountry’s strategy for developing its cooperatives.

Madagascar is a “good” example of how different definitions and interpretations of financial services coops can be and how in turn that makes it quite impossible for financial authorities to effectively regulate them and encourage them to provide sustainable professional financial services to otherwise unbanked people. Several donors identified cooperative societies as an ideal legal status and operational model for microfinance in Madagascar, one of the world’s largest islands with a widely dispersed, poor population (of over 19 million, about 85% of who live below 2 US$ a day) and an underdeveloped infrastructure. In the 1990-ies the lead development aid agency the World Bank coordinated a MF strategy in which the island was subdivided to allow simultaneous development of MFIs that would not compete with each other. The cooperative MFIs were created and supportedby donors such as World Bank itself, UNOs UNDP-UNCDF and FAO, the European Union, ILO, the African Development Bank, IFAD, WOCCU, the French government aid agency AFD, Canadian Desjardins, Swiss government, USAID, French NGO’s SIDI, ICAR, FERT and CIDR, French cooperative bank Credit Agricole, Dutch cooperative RABO bank and the German GTZ who supported the national MF association for the cooperative MFIs.